Why Scandals Beef Up Bottom Lines

Why you should care

Maybe scandal hunting isn’t such a bad investment strategy.

By Nathan Siegel

The Daily DoseFEB 18 2016

Once famous for being the most aggressive deal-maker in corporate America, Dennis Kozlowski soon gained another type of infamy, for siphoning millions of dollars from his company. After his 2002 ouster, the former CEO of Tyco International traded in a $6,000 shower curtain, among other lavish goods that the illegal money covered, for a 25-year prison sentence.

But here’s a question: Did he really hurt the company?

In a new study published in Applied Economics, researchers tracked the bottom-line results in 80 tabloid-worthy shit storms that involved a CEO over the past two decades. Not surprisingly, the following weeks and year were dismal for shareholders and the company alike, as investor confidence is shaken and the firm gets reformed. However, afterwards the company reaches new heights of success:

That’s the seemingly counterintuitive conclusion of Surendranath Jory, a professor of economics at the University of Sussex, who measured these companies’ return on assets, or profit divided by assets, in post-scandal years. “I was kinda surprised,” he says. (In case you’re wondering, Tyco’s stock fell 80 percent six weeks after Kozlowski starting making headlines, only to net a cool $3 billion three years later.)

Jory says the reason is that these firms tend to institute hard-to-swallow reforms to get investors and shareholders back on their side. While the changes wouldn’t really appeal to rule-following firms, they are better for business down the road, he argues. After Kozlowski’s epic fall from corporate stardom, Tyco changed the entire corporate-management team, replaced the board, beefed up internal audits and hired an executive in charge of compliance. Drastic, sure, but not a bad long-term strategy, scandal or not.

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Percentage by which formerly scandalous companies outperform their competition after three years.

It should be a wake-up call to investors and stockholders who bail at the first sign of crisis. Should they hold on a few years, not only might prices rebound, but the companies could also leave competitors in the dust. Taking it one step further raises the question: Should investors go scandal hunting and buy stocks right after a CEO gets caught using company funds to pay for a $2.1 million birthday party for his wife, for example? Jory doesn’t rule it out: “Once the initial shock has died down, why not?”

Some experts aren’t sold. Despite scandal-hit companies showing improvement on return on assets, investing in scandalous companies is not necessarily a good strategy. “The results could be a statistical fluke,” says Terrance Odean, a professor of finance at the University of California, Berkeley: “I wouldn’t bet my pocketbook.” Odean says we’d be better off investing in low-cost, well-diversified mutual funds such as index funds. Which may make more financial sense, but it doesn’t have the zing of scandal hunting, does it?